Competition and Loan Contracting: Evidence From Covenants and Performance Pricing
50 Pages Posted: 19 Mar 2014 Last revised: 22 Mar 2024
Date Written: September 1, 2021
Abstract
Product market threats shape loan contracting, in particular, performance-sensitive provisions, through two possible channels: A predation channel where the optimal loan contract, in light of rivals’ incentives to undertake predatory strategies, must lower the use of performance sensitive terms to avoid the adverse effects of triggering these terms; and a governance channel where competition mitigates borrowers’ agency issues, and hence reduces the demand for bank monitoring through performance-sensitive terms. Both channels predict a negative effect of product market threats on loan performance-sensitivity. We provide strong empirical evidence for this prediction by studying covenants and performance-pricing. Based on evidence from covenant violations and borrower vulnerability to product market competition, we further show that the predation channel is the dominating channel.
Keywords: competition, covenants, performance pricing, bank loans, governance
JEL Classification: G20, G21, G30, G32, L10, L20
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